Financial reporting rules, and the regulators who enforce those rules, protect investors from bad actors and can improve a company’s operational efficiency.
But research suggests that there’s a downside when regulators increase transparency in financial markets. In some cases, the costs outweigh the benefits, according to Chicago Booth’s Hans B. Christensen and Mark G. Maffett and Booth PhD candidate Lisa Yao Liu.
To study this, they tracked stock-price movements on the London Stock Exchange in response to an annual announcement of which “focus sectors” were likely to receive extra examination in the coming fiscal year by the Financial Reporting Review Panel (FRRP), a UK regulatory agency, from 2004 to 2011.
The simple threat of increased enforcement in the coming year was responsible for the price drops, the researchers note, rather than news of financial impropriety.
When the regulators singled out specific sectors for possible increased scrutiny, the stocks in those sectors fell nearly 2 percent over the following eight trading days relative to the performance of sectors that weren’t singled out—representing a median loss to investors of about $3 million.
The simple threat of increased enforcement in the coming year was responsible for the price drops, the researchers note, rather than news of financial impropriety. The stock reaction also reflects the lower risk of enforcement for sectors not targeted, the researchers write. They estimate that for companies in a targeted sector, the likelihood of being subject to increased scrutiny rose almost 150 percent.
“The results in this paper do not contradict prior evidence that financial reporting enforcement causes (or is associated with) transparency improvements and capital market benefits,” write Christensen, Liu, and Maffett. “The difference in our paper is that we can observe the net benefits to shareholders of increased transparency—in this case, the costs exceed the benefits.”
Besides the drop in stock values for targeted sectors, the researchers report that companies also “make significant changes in resource allocation following an increase in enforcement intensity.” Audit fees for companies involved in the proactive-enforcement program rose an average of 8 percent in subsequent years, and management strategy took on a more short-term focus, the researchers find.
“The permanent increases in compliance costs and myopic investment arising from increased enforcement contribute to the observed declines in equity values,” the researchers conclude.